A standard assumption of trade theory is that trade liberalization brings about efficiency and, consequently, welfare gains. With regard to preferential liberalization, however removing some distortions while leaving others intact may not make a country better off and, even if it does, may only do so temporarily. In this article, I present some of the effects of preferential trade liberalization by summarizing key messages from a simulation analysis of Honduras and DR-CAFTA undertaken in Medvedev (2008). 1

First, welfare gains from bilateral tariff reform with the US for Honduras are likely to be very modest, less than 0.1 percent of GDP. This is due to the fact that very little additional market opening takes place in the US, while Honduran producers face increased import competition and the government must make up the budgetary shortfall from lower tariff revenues by raising taxes or limiting spending. To get this result, rather than removing all protection at once, I take into account the gradual phase-in of tariff reductions as well as product exclusions and the different reduction schedules by sector (agriculture vs. manufacturing). One important caveat is that I do not consider the liberalization of services -which could potentially lead to larger gains- due to difficulties in quantifying service barriers.

Second, bilateral tariff reform favours agricultural producers of export crops, while manufacturing output rises less and production of domestic-oriented agriculture actually declines. These results differ from studies focusing on Central America as a whole (e.g., Francois et al., 2005), which argue that the largest increases in production are likely to take place in the textiles and apparel sector, but are consistent with the analysis of Bussolo and Niimi (2006) for Nicaragua, where agricultural production tends to increase more. This suggests that the outcomes for the poorest members of DR-CAFTA —Honduras and Nicaragua— are likely to differ substantially from the aggregate results for Central America. The sectoral results imply that trade reform is likely to be particularly beneficial for owners of capital and land, while unskilled workers gain the least and unskilled workers in the farm sector actually lose. Although the analysis is not accompanied by micro-simulations that could translate the changes in factor returns and consumption prices into poverty outcomes, the marginal effects of preferential liberalization under DR-CAFTA are unlikely to be beneficial for the poor, who tend to earn most of their income from unskilled labor and are usually concentrated in the agriculture sector. Furthermore, wage inequality between farm and non-farm workers could rise, although ultimately the effects on poverty and inequality will depend on the presence and design of complementary policies.

Third, the implementation of DR-CAFTA throughout all partner countries (i.e., the opening of other developing members markets) leads to significantly larger welfare gains of 0.7 percent of GDP. Furthermore, this “multilateral” DR-CAFTA scenario benefits manufacturing production relatively more than farm output, and results in an acceleration of growth in farm and non-farm wages alike.

Fourth, while neither of the DR-CAFTA liberalization scenarios is fully consistent with the pattern of sectoral adjustment that is likely to occur under a global free trade scenario, the “multilateral” DR-CAFTA is much more congruent with full liberalization than a bilateral DR-CAFTA with the US. In other words, the bilateral DR-CAFTA attracts labour to sectors that are likely to expand relatively less under global free trade and, should further global liberalization take place, Honduras may be faced with significant adjustment costs as movement of labour across sectors is rarely frictionless.

Fifth, the potential gains from non-trade channels are likely to be greater than the gains from tariff liberalization alone. The provisions of DR-CAFTA include a significant scope for liberalization of investment flows between the agreement members. If DR-CAFTA leads to an increase in net FDI inflows (in percentage terms) roughly compared to that experienced by Mexico in the first three years following the implementation of NAFTA, welfare gains from just the bilateral reform could rise to 1.9 percent of GDP by 2016. Therefore, investment rather than trade is likely to be the key to maximizing benefits from preferential liberalization for Honduras.

The results suggest that while some doubts about DR-CAFTA have not been baseless, the agreement can be an important part of the development strategy of Honduras. To maximize the potential of DR-CAFTA, there are several areas for policy attention by the government. First, policy makers should recognize that most trade barriers are likely to be found among the developing trading partners and thus focus their attention on obtaining improved market access to countries where the trade benefits are likely to be significant (such as the CACM partners). This is consistent with the analysis of Medvedev (2010), who showed that South-South PTAs tend to have the largest trade creation effects. Second, although Honduras is likely to receive little by way of additional market access to the US, the benefits of “deep integration” with high income partners could be large. The estimates in Medvedev (2006) showed that the ex post relationship between preferential liberalization and increased net FDI inflows is driven by North-South and South-South PTAs, and the magnitude of the expected FDI benefits is increasing in the incomes of PTA partners. Thus, a properly implemented “deep integration” agreement with the US could bring significant net FDI inflows and result in welfare gains that are orders of magnitude above the welfare increases from bilateral trade reform alone.

It should be emphasized that these benefits are not certain and that DR-CAFTA could also present a number of challenges to the Honduran policy makers. First, the budgetary implications of tariff reform need to be carefully considered. Further progress on the social agenda and the Millennium Development Goals would require replacing the lost tariff revenue by alternative tax collection mechanisms. Otherwise, public spending may need to be cut, which could also inhibit some of the policies Honduras needs to attract the potential FDI, such as investments in education and infrastructure. Second, the potential widening of wage inequality following trade reform may erode support for future reforms as well as increase the demand for public services that help workers adjust to these shocks. Third, the sequencing of policy reforms also requires the attention of policy-makers. The pattern of structural changes implied by DR-CAFTA (especially when the agreement is implemented as a hub-and-spoke arrangement) may not be consistent with Honduras' comparative advantages under free trade and, should multilateral free trade talks advance, additional costly labour adjustments may need to take place. Thus, Honduras should prioritize the pursuit of additional liberalization vis-a-vis other trading partners to more closely align the sectors that receive preferential access with the sectors where it has a global comparative advantage. 2 Fourth, maximizing the potential investment benefits from DR-CAFTA may require additional investments in infrastructure, education, health, sanitation, public safety, etc., to create an investment climate conducive not only to attracting FDI, but also to encouraging horizontal and backward linkages between foreign affiliates and domestic firms. However, this is likely to make the public revenue constraints even more binding.

Notes:* Economic Policy Unit, Latin America and the Caribbean Region, The World Bank. The views expressed here are those of the author and should not be attributed to the World Bank, its Executive Directors, or the countries they represent. This article is an executive summary of \Preferential Liberalization and Its Economy-Wide Effects in Honduras,” World Bank Policy Research Working Paper 4537.back to text1. The paper used a dynamic recursive computable general equilibrium (CGE) model to simulate a series of DR-CAFTA scenarios from 2004 to 2016. back to text2. The same point applies to the transition from a hub-and-spoke DR-CAFTA arrangement to a comprehensive regional agreement, suggesting that the longer full implementation is delayed the less Honduras is able to benefit from the agreement. back to text

Denis Medvedev is an economist in the Economic Policy group at the Latin America and the Caribbean region of the World Bank. His previous assignments in the World Bank included working in the Africa region and in the Development Prospects group. His research interests span a range of subjects including international trade, the Millennium Development Goals, income distribution dynamics, and climate change. He holds a Ph.D. from the American University.

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